You’ve worked hard to earn a profit in your company…..now what do you do with it?
Profit up to $500k in a DPC is taxed at a combined rate in Ontario of 12.2%. This is one of the lowest tax rates you will ever pay. Once you’ve paid this tax, does it make sense to invest the after-tax money from within your corporation? Or are you better to pay it out to yourself, and invest it personally?
There are a few factors at play:
- You have a lot more to invest if you keep it in the corporation
- You might lose your low corporate tax rate if you earn too much investment income
- Your salary/dividend strategy for paying yourself
- You are likely to sell your company some day
In Part 1, we look at each of these factors separately. In Part 2 we return to evaluate the combined effect and offer some possible tactics to maximize your situation.
A company with $100,000 operating profit will have $87,800 left in the corporation after tax. This is substantially more dollars available for investment than paying the $87,800 out as a dividend. At the highest marginal tax rate an $87,800 dividend will leave you with $45,884 in your personal hands to invest. Over time, the higher investment dollars in the corporation will give you access to better opportunities, lower fees and greater ability to diversify. You’ll have a larger amount of money compounding at a better rate.
Small Business Claw-back
The first Trudeau budget took aim at the tax-deferral above and punished small business owners that invest too much from within their business. Once your corporate investment income exceeds $50,000 per year, your operating profit from running your practice starts to get taxed at a higher rate. By the time you reach $150,000 in investment income, you are paying corporate tax on your operating income at 26.5% instead of 12.2%. While this is still lower than your personal tax rate, it is does affect your annual investible capital. It’s not quite as bad as it seems, however. The integration in our tax system means that as you start to pay a higher corporate tax rate on operating income, you will pay a lower tax rate on any dividends you pay yourself. So although the claw-back could leave you with less to invest each year, there is only a 1.3% difference when the money is ultimately paid out as a dividend.
On the surface, it looks like the tax rates on investment income are fairly similar whether you invest within the corporation or on a personal basis. Corporate investment income is taxed at 50.17% while personal investment income is taxed at 53.53%(at the highest rate) on a personal basis. However, about ½ of the corporate tax is refundable if you payout a taxable dividend to shareholders. If you pay yourself dividends every year to support your living expenses, this will trigger a refund of some of the corporate investment tax. This effectively lowers the tax rate on investments to approximately 25%.
Don’t Lose Your Capital Gains Exemption
Every Canadian is entitled to an exemption on the first $883,384 of capital gains on the sale of shares of a small business. This is a savings in tax of approximately $234,000 on the sale of business. If there are multiple family members as shareholders, they are each entitled to this exemption. However, an accumulation of investible assets inside the corporation can disqualify the capital gains exemption. The company must pass two tests with respect to its assets in order for the exemption to apply:
- For the entire two year period prior to the sale, no more than 50% of the assets can be passive – investments are considered passive assets.
- On the date of the sale, passive assets must be no more than 10% of total assets.
Since DPCs don’t generally have significant operating assets, investing from within the corporation can quickly exceed these thresholds.
As you can see, there is a mix of short term and long term considerations when planning where best to invest. The ability to defer tax is attractive, especially if the overall impact to personal income is marginal over one’s life-time. However, the thought of losing the prized Capital Gains Exemption on sale of the business is not to be taken lightly. Stay tuned for Part 2 where we discuss some ways to navigate these variables into an optimal solution for you and your family.